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Stock Exchange Fees Distort Markets -- Pragma Report

Brokers are unlikely to put their customers’ interests first as long as exchanges pay them more in maker-taker fees that they earn from commissions.

“One negative effect of this system is the conflict of interest it creates between brokers and their clients who pay a flat commission,” said David Mechner, CEO of Pragma, a provider of trading solutions and frequent contributor of reports on market conditions. The company recently issued a new report, “A Conflict Inherent in the MakerTaker Model: Equities vs. Futures.”

An earlier report looked at the conflict agency brokers face with passive limit orders. The new report looks at the conflict agency brokers face when deciding whether to cross the bid-ask spread.

“Brokers are in a very tough situation,” said Mechner,. “There is little they can do about this conflict other than urge clients to adopt the cost-plus model.” In that model, which many hedge funds use, the broker charges a commission and if there is a fee or rebate at the end of the month, the broker will charge or rebate it to the client. Hedge funds and proprietary trading firms can use that, but institutional asset managers aren’t set up to employ that model, he added. For them it becomes more complicated because of regulations on how prices are allocated to different investors.

The new report looks at quote imbalance as a predictor of short-term price movements.

“…a broker can use even rudimentary microstructure signals such as this to generate a significant performance improvement for his clients who pay a flat per-share fee, simply by crossing the spread when the quote imbalance is high enough.” (See the charts on the blog site for more.)

But when it is the biggest benefit to the client for the broker to cross the spread is the exact moment when it is most expensive to the broker to be aggressive.

The problem is the market structure and the lack of action by regulators.

“It is not realistic to expect true cost blindness from brokers, given where commissions are compared to fees and rebates,” Melcher added. “We see it as a structural issue, an inherent conflict in the market structure.”

It is useful for the buy-side to understand the issues, but brokers find it difficult to talk about, he said.

“There is very little transparency, very little discussion. We have said we think the maker taker model should be limited or ended. There’s not much you can do from the fundamental level except to support regulatory change.”

Buy-side firms can use a broker neutral platform like FlexTrade or Portware or they can take more control of their own trading, he said. Developing their own models and algorithms for trading could be difficult, he added.

“It’s a bit of a challenge because it requires a distinct skill set — quants who understand market structure and work with tick data and are also good programmers. Small shops that are tech savvy do it more often than the bigger institutional shops.”

Prgma contrasts the equities markets with futures traded on the CME which does not offer diffferntial fees or debates.

“The explicit cost of the aggressive and passive strategies are the same, and are independent of the quote imbalance. Thus, we observe that the same conflicts of interest found in the equity markets do not exist between clients trading futures and their brokers.”

Maker-taker models with their fees for brokers have proven they provide competitive value, but at the expense of clients. They present one of those conflicts for which Wall Street is famous, but no regulators have contacted Pragma on its research.

“When a client pays a flat per-share commission, this maker-taker market structure creates an intractable problem for brokers—being truly blind to fees and rebates would have a dramatic effect on profitability and would even render business at the lower end of current commission levels unprofitable,” notes Pragma. “Regulators should eliminate or limit rebates and similar payments for order flow. Such rebates obscure the true economics of the services brokers provide, create market distortions, and create unnecessary and inescapable misalignments of interest between broker and flat commission clients.”

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